Active Funds Protect In A Down Market… Debunked

With all the attention given to to the exploding passive indexation movement, be it through Exchange Traded Funds (ETFs) or Index Mutual Funds, much praise has been given to the low fees and full market participation during bull runs. There have been countless studies that extol the virtues of investing in indexed products over long periods of time for the average investor, but the last bastion of hope for the active management proponents has been the claim that “active managers can protect in a down market”. There has never been any supporting evidence that has really backed up these claims (other than the odd cherry-picking comparison), yet this remains a firm battle-cry for active-management nonetheless.

Well, as Allan Roth points out, we’re in a down market so let’s ante up. The blinds are in and though we might be waiting for the river card to be turned over yet (we might not be through the down market is what I’m getting at), it looks like index funds have managed to outperform even in the downturn. He cites the Morningstar ratings for three popular index funds as proxies for index funds in general, the Vanguard Total Stock Market Index for the US index, the Vanguard Total International Stock Index for global stocks and the Vanguard Total Bond Index for bonds.

The Morningstar numbers represent the percentile in which the performance of a fund ranks against it’s peers, so a rating of 1 means a fund is in the top 1% of returns for a peer group and a 100 rating means the fund is basically the worst (so a lower number is better). Therefore, if index funds were expected to underperform active management they should have a Morningstar number dramatically above 50 meaning that their return is worse than the average active fund.

The author explains that the reason for this may be simple arithmetic since just as active management has an almost 2% fee hurdle to overcome in an up market, the same holds true in a down market lest anyone forget. In fact, he goes so far as to say that anyone who argues that active management protects in a down market doesn’t believe in arithmetic. You can read his original article by clicking here.

There have been severe down markets where actively-managed funds have performed comparably to indexes, but this can also be explained by cash holdings.

PreetMay 7th, 2008 04:03 AM

Excellent point Michael James. I have also not seen any evidence to suggest that managers who do hold substantial cash positions switched to cash before any initial downturn in performance (i.e. sometimes the cash positions come too late). I think a certain amount of their cash holding can be attributed to knowing that investor redemptions are ramping up as well.